Central Clearing of OTC Derivatives in Australia – June 2011 1. Background

1.1. Introduction

In September 2009 the leaders of the G20 group of countries, of which Australia is a member, made a number of commitments regarding reforms to global financial markets. One of these was specifically focused on over the-counter (OTC) derivatives markets:

‘All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements. We ask the FSB [Financial Stability Board] and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.’[1]

In the period since then, G20 members and other countries have begun reforming the regulation of OTC derivatives markets within their jurisdictions. Revised regulatory frameworks have been legislated or proposed in economies with large OTC derivatives markets, such as the European Union, Japan and the United States, while other jurisdictions have also begun moving. In parallel, revisions to associated standards and guidance have been undertaken by international standard-setting bodies, and the FSB has issued a set of recommendations for countries when implementing regulatory reforms for OTC derivatives.

The Australian Council of Financial Regulators – comprising senior representatives of the Australian Prudential Regulation Authority (APRA), the Australian Securities and Investments Commission (ASIC), the Reserve Bank of Australia and the Treasury – has been considering how the G20 commitment can be best implemented in Australia. The Council agencies' initial focus has been on how Australia should meet its G20 commitment in relation to the central clearing of OTC derivatives. The Council has also been considering other aspects of the G20 commitment, such as reporting to trade repositories, and will develop recommendations to the Government on these in due course.

1.2. Regulatory Concerns Regarding OTC Derivatives

The G20 commitment on OTC derivatives came in the wake of a severe global financial crisis, during which a significant source of uncertainty had been the functioning of some OTC derivatives markets.[2] Neither regulators nor market participants felt they had a good understanding of exposures and linkages within these markets.

There was little confidence that available bilateral risk management tools had been utilised appropriately in all segments of the OTC derivatives markets, or had been effective in dealing with the stresses in the market. Moreover, the inherent interconnectedness of these markets meant that OTC derivatives were a prime channel through which distress in one institution or location could be transmitted to others.

Concerns over the lack of transparency and risk management shortcomings in some OTC derivatives markets had in fact been on regulators' minds for several years prior to the financial crisis. Unlike traditional exchange-traded derivatives contracts – which are highly standardised and typically of quite short duration – the long maturity and bespoke nature of many OTC derivatives transactions create a heavier risk management burden for participants in these markets. As well, cumbersome bilateral processes can mean that economically redundant positions contribute to a build up of large gross notional positions outstanding, further increasing interdependencies and complexities for market participants.

Regulators and industry participants had therefore periodically reviewed risk management practices as the market grew.[3] The past decade, though, saw accelerating product innovation and growth in volumes and exposures, particularly in the credit derivatives market. To discuss regulatory concerns, in 2005 the Federal Reserve Bank of New York began convening a series of meetings between regulators from the major markets and representatives of the largest globally active dealers. This process has led to a series of incremental improvements in risk mitigation practices for large dealers, particularly in the credit derivatives market. The process has also contributed to a wider international debate on these issues. In April 2008, the Financial Stability Forum, the predecessor of the FSB, released a report that included recommendations addressing the legal and operational infrastructure underpinning OTC derivatives markets.[4]

In response to this call, APRA, ASIC and the Reserve Bank undertook a survey of risk management and other practices in the OTC derivatives market in Australia, with a report published jointly in May 2009.[5]

The survey found that the overall level of activity in Australia, while large in a domestic context, was low relative to major offshore markets. Within the local market, trading was dominated by interest rate and foreign exchange (FX) derivatives, with only small amounts of activity in equity, commodity and credit derivatives. Moreover, the types of products and the nature of participants and their use of derivatives were fairly straightforward compared to some offshore markets.

Although no immediate concerns were identified, the regulators noted that there was some scope for improvements in market practices. It was noted that while a capacity to centrally clear positions transacted within the Australian market did not appear likely within the near future, the benefits of central clearing could be substantial, and therefore participants were encouraged to explore the potential for this as the local market grew and the range of CCP services expanded.

In the meantime, authorities in major markets were working through the consequences of the financial crisis, and considering how the resilience of their financial systems could be improved. An obvious candidate in this respect was to push for enhancements to the practices and infrastructure underpinning OTC derivatives markets, including steps to reduce the interconnectedness of participants. But given the cross-border nature of these markets – and particularly the prospect of regulatory arbitrage between jurisdictions – some international co-ordination of regulatory action was seen to be desirable. This was manifested in the G20 commitment.

1.3. International Regulatory Reforms

1.3.1. National responses

Subsequent to this commitment, over the course of 2010 and into 2011 a number of countries have been developing substantial reform agendas for OTC derivatives markets within their jurisdictions. In most cases, though, national regulators are still at a very preliminary stage of developing policies.[6] Even in countries with a more advanced reform program, many details of implementation remain to be finalised, covering issues such as: the scope of regulators' jurisdiction over transactions and participants; how and when exemptions for any central clearing obligation will be granted; the definition and determination of product classes to which a clearing requirement will apply; and the co-ordination of regulatory oversight arrangements for globally significant CCPs clearing OTC derivatives.

Perhaps most prominently, in the United States the Dodd-Frank Act, passed in mid 2010, will require US-regulated entities to centrally clear all instruments that regulators have deemed to be clearable.[7] If a market participant is not a clearing participant of the relevant CCP, it must clear through an existing clearing participant. Proposed legislation in Europe (European Markets Infrastructure Regulation, or EMIR) will have similar effect, as does legislation enacted in Japan in early 2010.[8],[9]

Clearing requirements set out in these three large jurisdictions are similar in that they provide for both a ‘top-down’ and ‘bottom-up’ approach to determining whether a set of contracts will be required to be centrally cleared. Under the top-down approach, a relevant regulator within each jurisdiction has the authority to designate certain contracts as clearable, whether or not a CCP that can clear these products has been licensed within that jurisdiction. In part, the purpose of this approach is to overcome a possible failure of industry co-ordination to move to central clearing. The bottom-up approach, in contrast, allows for a more industry-led process, where authorities can designate a set of products as mandatorily clearable if and when a CCP has requested and been granted a licence to clear those products.

Although the requirement to centrally clear is designed to apply widely across market participants and products, in practice a more limited set of activity will be captured. Regulators have recognised that not all OTC derivatives products are amenable to central clearing, and that in some cases central clearing may not result in a material reduction in systemic risk. For instance, important classes of FX derivatives have been exempted from central clearing requirements in the United States, while complex or illiquid products are unlikely to be designated as clearable.[10] Given this, regulators are considering whether non-cleared derivatives will also be subject to minimum margin requirements, both to ensure that all derivative positions are adequately supported by financial resources, and to maintain participants’ incentives to centrally clear transactions where possible. In addition, so as to maintain high levels of transparency (both for market participants and regulators) around non-centrally cleared transactions, regulators in the European Union and the United States are also requiring all OTC derivatives transactions to be reported to trade repositories.

As yet, US regulators are yet to make a detailed enumeration of clearable derivatives. Other jurisdictions are likely to harmonise their requirements with this so as to avoid regulatory arbitrage opportunities (indeed, the FSB is attempting to achieve internationally co-ordinated outcomes on this as much as possible). In terms of for whom a clearing requirement will be mandatory, final exemptions are still being determined. In general, financial institutions (whether dealers or clients) will be required to centrally clear, while exemptions will exist for corporations that might be using products purely for hedging purposes, some government entities and other smaller market participants. There is some possibility that offshore jurisdictions’ provisions will have an extraterritorial effect, though the extent of this is unclear at present.

In mandating central clearing for a wide range of market participants, legislators and regulators in the European Union and the United States have taken account of some of the risks posed by CCPs (discussed further in Section 2). Recognising the systemic importance of CCPs – and that this is likely to grow as a result of mandatory clearing requirements – stringent risk management frameworks for CCPs are being imposed in these jurisdictions. As well, the potential for a CCP to face financial difficulty (no matter how remote) has also been a factor in designing some elements of the regulatory frameworks. In the United States, for instance, Title VIII of the Dodd-Frank Act provides for financial market utilities such as CCPs to be designated as systemically important, increasing the oversight capacities and enforcement powers available to US regulators, and authorising the Federal Reserve to provide (limited and strictly controlled) support to CCPs in times of market emergencies. The European legislative proposal also acknowledges the potential for CCP distress; since the member state that is the home jurisdiction for such a CCP might bear prime fiscal responsibility in such a situation, EMIR provides that regulators in that jurisdiction are given lead responsibility in the CCP's supervision.[11] To provide additional protections to market participants that are being forced to clear transactions, but that may not be willing or able to join a CCP as a clearing member, legislation in these jurisdictions also seeks to enhance the portability and segregation of clients' collateral and positions in the event of a clearing member default. For these provisions to be fully effective, a number of jurisdictions will likely require changes to insolvency laws.

1.3.2. Multilateral responses

In parallel with these various national reform agendas, significant work has been undertaken in multilateral fora. The Basel Committee on Banking Supervision (BCBS) has been working on revisions to capital standards that should encourage banks to clear their OTC derivatives positions through CCPs.[12] The capital weighting on bilateral counterparty exposures will be increased, while exposures to a CCP will be afforded a weighting that is low (but non-zero). While some details of these arrangements are still to be finalised, banks with large or complex configurations of bilateral OTC derivatives exposures will likely have a strong incentive to move these to CCPs over time. In part reflecting the expanded role of CCPs, the Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) have issued new principles to guide the oversight of infrastructure supporting these markets.[13]

An important context for Australian agencies in developing a reform agenda with respect to OTC derivatives is a set of recommendations issued by the FSB.[14] These recommendations focus on the areas of standardisation of products and practices, central clearing, exchange or electronic platform trading, and reporting to trade repositories. It is acknowledged that national authorities will need some flexibility in structuring their approach across these areas. The recommendations with respect to central clearing discuss: how to identify which products are amenable to central clearing (acknowledging that some products will inevitably remain on a bilateral basis); where clearing should be mandatory or voluntary; and where exemptions may be appropriate.


Group of 20, Pittsburgh Summit Leaders' Statement, September 24–25 2009, available at: <http://www.g20.org/Documents/pittsburgh_summit_leaders_statement_250909.pdf>. [1]

For a discussion of the interaction of wholesale financial markets, the roles of large dealers, and the difficulties this can pose in crisis situations, see Duffie (2010). [2]

See, for instance, CPSS (1998), Counterparty Risk Management Policy Group (2005) and CPSS (2007). [3]

Financial Stability Forum (2008). [4]

APRA, ASIC, and RBA (2009). [5]

For a report on the state of international reform in this area, see FSB (2011a). [6]

The text of the Dodd-Frank Act is available at: <http://www.gpo.gov/fdsys/pkg/PLAW-111publ203/pdf/PLAW-111publ203.pdf>. [7]

The draft EMIR legislation as proposed by the European Council as at 6 June 2011 is available at: <http://register.consilium.europa.eu/pdf/en/11/st10/st11058.en11.pdf>. [8]

In May 2010 the Japanese Diet passed relevant amendments to the Financial Instruments and Exchange Act. [9]

The US Treasury's decision regarding an exemption for certain FX derivatives is available at: <http://www.treasury.gov/initiatives/wsr/Documents/FX%20Swaps%20and%20Forwards%20NPD.pdf>. [10]

Draft EMIR preamble, paragraph (30). [11]

BCBS (2010a). [12]

CPSS-IOSCO (2011). [13]

FSB (2010). [14]